As a college student, should I continue investing or save to pay off my debt first?
I currently have $9,000 dollars in student debt, and I still have one more year of college left which will cost roughly $10,000 or more with food expenses for that year, plus an additional one year of grad school at a NYS public university which will I have to pay tuition and living expenses for.
Should I maximize contributions to my IRA for this year? I have $11,000 in savings and I will be going back this summer to my internship where I will earn $5,000 and then will have an internship for the following summer making roughly $25 an hour (about double my current pay rate). I don't want to miss out on a year or two of investing, but I also want to pay off my debt and anticipated debt. I currently have two years worth of full contributions in my IRA.
It's great that you’re taking charge of your financial future by investing, and you stand to benefit greatly from compounding interest over time. Paying down debt versus saving for the future is one of the classic financial tradeoffs for young people to consider. Ultimately, putting money towards your loans is a positive thing, so you can’t go wrong contributing more, but you can optimize how you choose to divvy up your funds so that you can save for retirement and manage other more immediate expenses simultaneously. The biggest factor in this decision is typically the interest rate on the loan - student loans are not viewed as “bad debt” (example of “bad debt” is debt that carries a balance on your credit card), so having loans that you pay off over time can be a smart way to balance your overall financial picture. If, for example, you are borrowing at 4% on a student loan and investing in an IRA with a long term growth expectation of 8%, the spread works in your favor. If instead you are borrowing at 4% and holding excess cash in a checking account yielding 0%, the spread does not work in your favor and the cash would be better used to pay off the debt.
This may seem obvious, but it can get complicated if you have multiple loans and/or multiple servicers. Take stock of how much each loan is for and the interest rate on each so you can begin prioritizing the loans with higher interest (usually those exceeding 5%) and pay them off faster to avoid accruing more interest than you need to.
As your financial priorities shift in college and beyond, make sure you’re increasing your emergency fund to match your growing expenses, like increased costs for rent and groceries, and are adapting your investing strategy to meet your short- and long-term financial goals. Once you graduate and get a job, make sure you explore any employer-sponsored retirement plans available, as those often come with tax advantages and matches that are like getting free money from your company.
First, let me start with Good Job on full funding your IRA for the past two years. That rocks! And it is something that I wish I would have done.
This is a great question that many individuals ask and I am glad you are asking it also. The math would likely promote that you fund you should fully fund your IRA. This is true if you are confident in good to great market returns on your IRA. Yet if Debt brings you stress and anxiety, you may want to focus on eliminating that expense. Personally I would go with the option that you are more excited about. This is the behavioral finance perspective. When you are excited about your goals, you are much more likely to achieve them. And in this case, both actions have a positive impact on your net-worth.
Moreover, the Debt has a known interest rate while the market rate is unknown. If this was Credit card debt in the double digits area of interest rates, crushing debt would be a priority. I am guessing your Student loans are relatively low?
Regardless, you should feel great about using your money wisely and the two full years of IRA savings. That is awesome momentum.
With love and regards,
Jose Sanchez, CFP®
You should definitely maximize your IRA contributions, and you should make them to a Roth IRA even if you will get a tax deduction for putting your money into a traditional IRA. The reason is that through the decades you will come out far ahead by having your money compounding truly tax-free in a Roth rather than in a traditional IRA where you--or an heir--will eventually have to pay taxes upon withdrawal presumably on a larger amount and at a higher tax rate than you are experiencing as a student. It is essential to develop the discipline to put the maximum in your Roth IRA each year even if you have student debt, parties, gifts, travel, and other expenses which you would like to satisfy. It is also almost certainly true that federal marginal tax rates in the future will be significantly higher than they are in 2018-2020. Also, when you have money in a traditional IRA, if you withdraw it as required once you reach age 70-1/2 then your income from the withdrawal will cause the tax on your social security checks to be significantly higher. With a Roth there is no required withdrawal and if you do take money out then it will not be taxed or increase the tax on your social security checks.
Paying off debt is an admirable goal and should be attacked aggressively in most cases to keep it under control. However, it can actually be more advantageous long-term to balance debt interest with potential investment returns. As a rule of thumb, if historic returns from a reasonable investment are greater than the loan interest, investing first while paying the debit over the full term can be your best outcome.
That's a really good question. My one follow-up is what your interest rate is on your student loans? That could help make the decision. If it's a relatively high interest rate, then most often, it's more beneficial to pay that off first and then save for retirement.
Without knowing your rate, here's what I think. Paying off that student loan debt as soon as possible will a) give you peace of mind knowing you don't owe anyone any money b) guarantee you a small rate of return by no longer owing the interest tied to the loan and c) give you the freedom to do with your future earnings as you please because of reason a. That freedom can, and should, include saving for retirement.
On the other hand, investing two more years worth of IRA contributions will give your account and investments a good opportunity to compound a few times over between now and retirement.
Now, nobody can predict the future, but some experts in economics think the market will decline in the next couple of years. I tend to be in that camp, as well. So waiting to invest until that happens, might not be a bad idea. Buy low, right? Along with that same line of thinking, your future earnings and employment are not guaranteed (though with a BA and a Masters, I would hope you'd have more success and security) so taking care of that debt while you do have the money and the earnings is also a good idea.
Ultimately, it comes down to what you are more comfortable with. Would you rather pay off the debt and rely on your future earnings to save for retirement? Or, would you rather save that money now, let compounding work its magic, and pay off your debt with your future earnings?
It's a tough decision to make. I hope this helps and wish you the best!